#160 | Policy Funding on the Margin

A couple of weeks ago, one of the subscribers to this site reached out about a curious calculation he’d run while reviewing a proposal for one of his clients. The basic crux of the question was why seemingly minor changes to the crediting rate of a policy resulted in massive changes in cash value in later policy years. Given that the product in question was an Indexed UL policy, he logically assumed that there was some convoluted policy mechanism at play that was producing these types of results. Sure enough, the product had an Index Credit Multiplier and a bonus. But that wasn’t the issue. Nope, the problem was something way more basic – Cost of Insurance charges.

As you know, COI charges are calculated by multiplying the applicable COI rate in any particular year by the current Net Amount at Risk (NAR). NAR is the difference between the policy death benefit and the account value. The theory behind deducting COI charges this way is simple. Even though the death benefit is what will paid to the beneficiary in the event of a claim, part of that money is a return of the account value and the remaining part is the life insurance, in the pure sense. As a result, COI charges are only deducted based on the insurance, which is the NAR. Doing it any other way would mean situations where clients were being overcharged (or undercharged) for the pure insurance coverage provided by the policy.

The problem, however, is that basing COI charges on Net Amount at Risk creates a feedback loop within the policy (or, in finance terms, nonlinearity). An extra dollar of premium, for example, isn’t just an extra dollar of premium – it earns compounding interest in the account value and, crucially, reduces NAR by one dollar as well, which in turn reduces COI charges. And to make matters more complicated, COI charges are based on COI rates that increase over time, so this extra dollar of premium has a varying impact depending on when its paid. These types of minute changes happen all of the time. An extra dollar of premium is equivalent to an extra dollar of credited interest, the rate of which can change every year. Taken together, life insurance is easily the most nonlinear of all financial instruments. Tiny changes can produce massive results in a way that is, frankly, astonishing.

Let’s take an example of a single premium policy on a 45 year old. Just to keep it simple, let’s assume that the single premium to have exactly $1 of cash value at age 121, 76 years in the future, is $200,000. What happens when we assume $200,001 of premium rather than $200,000? The crediting rate of the policy is 5%, so back-of-the-envelope math says that $1 of extra premium should be worth something like $20* at age 121. What’s it actually worth? $1,344,555. What’s the IRR on that extra dollar of premium? 21% compounding over 76 years. Tiny changes, huge results.

The change, of course, doesn’t happen at age 121. Well before that point, the policy funded with the extra $1 hits a break-point where it accelerates while the other scenario begins to peak and decline. It’s like what you imagine with a satellite orbiting the earth a hair’s breadth from a distance that will send it flying off into space. Either it orbits or flies off into infinity. Take a look at the two scenarios below.

This type of behavior only exists at the margin between lapse and endowment. Take a look at the marginal IRR of an extra dollar paid at various funding levels:

Funding for the absolute minimum always invites non-linearity into the results, which is a major problem in the real-world of policy administration. Take a look again at the graph of the divergence between the two scenarios. The crazy thing is that everything appears to be on track until suddenly it’s not. The gap between the scenarios accelerates rapidly. A policy review would have not have caught a problem – the gap was only a few dollars until, suddenly, it explodes.

Fortunately, there’s a quick fix. Fund policies appropriately, which is to say that they should be overfunded. If things work out well, then great, the client can reduce or stop paying premiums. But if you thin-fund the policy, then you’re inviting the situation where a seemingly tiny change creates huge problems on the in-force illustration. It’s not a fun conversation and it can be easily avoided by automatically adding 10% to any minimally illustrated premium. Think of it as buying an insurance policy on your insurance policy. And since we’re all in the insurance business, that should be an easy precaution to take.